Exposing the Magnitude of the Catastrophe?

When a "premier global consulting and actuarial" firm proves in its first Public Pension Funding study that those government pensions are doomed, it is past time for action. Milliman's study showing a 33 percent increase in pension debt over official numbers from a minute change in accounting should be enough to spur reform.

However, this hidden fiscal cancer threatening to consume the American economy and sabotage essential state and local government services gets even worse when you look at pension performance since the Jan. 1, 2012 cutoff date for the Milliman data.Those latest numbers show a system collapsing faster than the experts can calculate.

While Milliman's 2012 Public Pension Funding Survey calculates pension debt for the biggest 100 funds at almost $1.2 trillion instead of the official estimate of $895 billion as of the first of this year, performance through June 30 reported to U.S. Census shows it spiraling out of control.

From the quarter ending June 30, 2011, through the same quarter this year, taxpayers and government workers pumped $154 billion into Census' Top 100 government pension funds. Yet value of holdings declined $57.6 billion from the same quarter in 2011.

Worst of all, over that time pension funds paid out $149 billion more than they earned, devouring contributions instead of investing them to pay future benefits as promised.

The Census Quarterly Survey of Public Pensions collects data from state and municipal pension funds representing 89.4 percent of "financial activity." Census estimates there are 3,418 state and municipal pension funds in the U.S.

Worst news of all is that Q2 earnings on investments were negative $14.2 billion, a $66 billion decline from the same quarter last year.In the course of one year, for every $1 taxpayers and workers put in, pension fund managers lost and paid out $2. How long can that go on?

Every year pensions must invest all contributions to pay future benefits. Investments must grow enough and earn enough income every year to pay benefits and expenses. If they do not, eventually the pension fund must run out of money. Every year they fall behind, the fiscal abyss gets deeper until it reaches a point of no return.

This totally blows away Milliman's attempt to offer "... an aggregate analysis of these 100 public pensions and their funded status."

In an effort to counter widespread criticism that politicians and pension fund managers cook the books to hide the true debt taxpayers must pay in coming decades for no government services of any kind, the Milliman study made minor changes to two current government pension accounting techniques.

Even though government pension accounting techniques are illegal for private sector pensions, politicians routinely use them to secretly evade balanced budget laws.

What Milliman found was that by just changing the assumed "discount rate" public pensions use to determine long-term value of investment assets from 8 percent to 7.65 percent and calculating that value on a market basis instead of actuarial basis, the debt increased almost $300 billion, 33 percent.

But that fails to show pension funds should have grown to the equivalent of $4.1 trillion instead of the actual $2.7 trillion reported as of June 30, putting the long-term debt at more than $5 trillion based on realistic calculations.

Milliman acknowledges, "Most pension plans suffered significant asset losses in the 2007-2009 time frame. While these losses were generally followed by sizeable gains during 2009-2011, those gains were typically not as large as the losses that preceded them, leading to plans generally having reported actuarial asset values larger than market values."

They do that by loading up portfolios with risky investments hoping returns will justify delusional assumptions.

According to Milliman, more than 70 percent of their 100 plans' investments are in stocks, real estate, private equity, hedge funds and commodities, which almost guarantees future gains will not make up future losses.

The small accounting changes in the study also cut pension funding level from the official 75 cents for every dollar owed to less than 68 cents.

Even that number is optimistic compared to a study for State Budget Solutions by Andrew Biggs -- using accounting standards universally accepted by economists - that proved as of 2011 state and municipal pensions could only pay 41 cents of every dollar they owe workers.

Actuaries who calculate pension funding levels say 80 cents on the dollar is the point at which a pension should be considered in crisis under most circumstances.Politicians expect private sector workers and businesses to make up the difference.

Milliman points out that aggregate numbers in the study do not necessarily apply to individual pension systems, and results can vary widely.

So, take a look at Wisconsin Retirement System, rated as 100 percent funded by Milliman and a "Solid Performer" by the Pew Center on the States.

In a study updated this year, economists Robert Novy-Marx and Joshua Rauh calculated the average Wisconsin household will have to pay more than $1,500 in additional taxes every year for 30 years just for pensions.

That is on top of all other rate hikes, new taxes and additional revenue from economic growth. Citizens will receive no governmental services of any kind in exchange for the extraordinary taxes.

If that is what fully funded means, taxpayers in other states might as well just turn their homes and businesses over to state and municipal workers now.Far from being reassuring, the first Milliman pension report must be one more call to action.

Numerous recent studies by a wide array of economists determined that under current policy and as presently operated, public pension funds eventually will run out of money. Employees and retirees covered by some plans will not get full benefits.

Can we ensure that public pensions are solvent, fair to employees, and capable of attracting high-quality individuals to public service? Pioneer has long known that reaching these goals will require a fundamental rethinking of our public pension system. We’ve produced numerous reports, gained several good reforms, and recognized courageous legislators like State Senator Will Brownsberger for serious reform proposals.

But we must do more – and now. This week, we begin releasing the first of a 10-part series on public pensions, focusing on the real unfunded liability for the state and localities.

In The Fiscal Implications of Massachusetts Retirement Boards' Investment Returns, Pioneer Senior Fellow on Finance Iliya Atanasov presents the projected costs for three scenarios to retire the state’s unfunded pension liability. The study shows that even minor fluctuations in investment returns can have dramatic impacts on the annual outlays governments will have to make to fund public pensions. That means short-changing other priorities like education, health care, and core government services.

Currently most every public pension fund assumes at least an 8% return. State Treasurer Steve Grossman deserves credit for recommending that we lower the annual rate of return (ARR) in Massachusetts from 8.25% to 8%, but with private firms working from 4.5 to 5% ARR and the state of Rhode Island moving to a 7.5% ARR, we need to look reality in the face. We’ve avoided the truly hard questions by papering over the real unfunded liability we face, doing things like extending the schedule for retiring the unfunded pension liability from 2025 to 2040. It’s time to get real.

Atanasov is right, it's high time all states get real about projected investment returns and lower their annual rate of return assumptions. If US public pension funds used the same discount rate as the Oracle of Ontario (5.4%), they'd be insolvent, forcing taxpayers to foot the bill.

Nonetheless, the main problem behind public pension deficits is not the high discount rate. In his Bloomberg comment, Peter Orszag, vice chairman of corporate and investment banking at Citigroup Inc. and a former director of the Office of Management and Budget in the Obama administration, writes, Pension Funding Scare Won’t Frighten All States:

State and local governments, struggling to emerge from the aftermath of the financial crisis, face another looming funding gap: in their public pensions. These plans hold almost $3 trillion in assets and cover more than 10 percent of U.S. workers, so they’re an important force in the economy.

Even under existing accounting rules, which make the pension math look good by allowing states to apply an artificially high discount rate to future liabilities, the average state pension plan holds assets equal to only about three-quarters of projected liabilities. The difference amounts to about a half-trillion dollars.

Under a lower discount rate that has been approved by the Government Accounting Standards Board and will have to be used by mid-2014 by states that are not meeting their annual required contributions, the difference is greater.

Using an even lower discount rate, one that many economists prefer, the gap would be as much as $2 trillion. Any way you do the calculation, clearly there’s a big problem.

Yet discussions about how to address it are based on flawed assumptions. The dominant view is that large state and local pension gaps are universal across the country, that they are caused largely by assuming too high a discount rate in assessing future liabilities, and that intransigent unions are to blame for the biggest gaps.

Myth Busting

Alicia Munnell, the director of the Center for Retirement Research at Boston College, takes on each of these myths in her new book, “State and Local Pensions: What Now?” Munnell, with whom I served in President Bill Clinton’s administration, has devoted most of her career to pension issues.

First, she computes a funding ratio -- that is, the ratio of assets to liabilities -- for each state plan. She finds substantial variation: Five percent of public pension plans, for example, were fully funded in 2010, and 35 percent had a funding ratio of at least 80 percent. On the other hand, 12 percent of plans had severe problems: Their assets were less than 60 percent of their projected liabilities.

The New York state teachers’ fund had assets fully equal to liabilities, whereas the New York City teachers’ fund had assets equal to 63 percent of its projected costs. Illinois, Kentucky and Pennsylvania face enormous gaps, while Delaware, Florida, North Carolina and Tennessee have managed their pension plans relatively well.

Why were some plans so badly underfunded and others not? Munnell’s answer is the biggest surprise in her analysis. She argues that neither the artificially high discount rate nor unions can explain the variation. As she concludes, “The poorly funded plans did not come close to surmounting the lower hurdle associated with a high discount rate; raising the hurdle is unlikely to have improved their behavior. And union strength simply did not show up as a statistically significant factor in any of the empirical analysis.”

The worst-funded plans were not especially generous in their benefits, Munnell found, which is consistent with her argument that union strength isn’t what matters. These plans, though, did tend to share two characteristics: They were disproportionately teachers’ plans, and they used a funding method (called the projected unit credit cost method) that is less stringent than those used by other plans.

The states with huge funding gaps have “behaved badly,” Munnell concludes. “They have either not made the required contributions or used inaccurate assumptions so that their contribution requirements are not meaningful.” She added, “Fiscal discipline simply appeared not to be part of the state’s culture.”

Growing Burden

In pensions, as in life, what goes around comes around. In states that have behaved well in the past -- such as Delaware -- the burden of pension plans will increase in future years only modestly if at all. In contrast, a state such as Illinois, which has perhaps the worst record of avoiding necessary funding even while expanding benefits, will have to increase its pension contributions sharply if it is to meet its obligations.

To get a sense of what looms, assume that, over the next three decades, the plans will earn an average nominal return of 6 percent on their assets. In that case, Illinois will have to raise contributions from less than 8 percent of total state revenue in 2009 to an average of 14 percent between 2014 and 2044. Delaware, in contrast, would need to raise its contribution by only 2 percent of state revenue. The required adjustments in the states with problems need not, and should not, be made overnight, but they will be a drag on state resources for a long time.

The revelation that problems exist mainly in states that have failed to adhere to a credible long-term funding strategy contains a lesson for policy makers in Washington: It is essential to behave responsibly.

Simply hoping our long-term fiscal problems will magically disappear is not a credible strategy. As part of the negotiations over how to address the fiscal cliff -- the federal spending cuts and tax increases scheduled to take effect in January -- policy makers should combine more support for the economy in 2013 (in the form of tax cuts and infrastructure spending) with a specific and credible deficit reduction plan that rolls out gradually over the next several decades.

Interestingly, Bloomberg reports that debt sold by Illinois issuers is rallying the most in 20 months in the face of a warning that the state’s pensions may run out of money and drain funding from education, infrastructure and local aid.Guess municipal bond investors aren't overly concerned about Illinois' pension deficits.

As I've written in the seven simple truths about public employee pensions, public pension deficits are the result of a decade of states taking pension holidays and raising benefits without paying for them, not the Great Recession. It only exposed the magnitude of the problem.

Moreover, Orszag is right, hoping long-term fiscal problems will magically disappear is not a credible strategy. To tackle public pension deficits, states need to implement much needed reforms, including sweeping governance reforms, bolstering defined-benefit plans and ensuring their long-term sustainability.

The dumbest measure promotes a shift out of defined-benefit into defined-contribution plans, placing the retirement onus entirely onto workers. As I've stated many times, the shift out of DB into DC plans is a shortsighted measure that will only exacerbate pension poverty, adding to America's 401(k) nightmare and long-term debt.

Speaking of nightmares, watch clip below as Bloomberg's Tom Keene and Sara Eisen talk through the destruction caused on the East Coast by Hurricane Sandy. They speak on Bloomberg Surveillance.

And former MTA Chairman Peter Kalikow talks about Hurricane Sandy's devastating impact on New York City's subway system. He speaks on Bloomberg Television's "Superstorm: State of Emergency."

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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